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How do you structure an EIUL to keep it from becoming an Modified Endowment Contract? October 16, 2009

Posted by shaferfinancial in Finance.
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One of my readers asked this question and I think it was a great question to answer in a post.

There are two IRS tests to determine if this is a modified endowment contract or life insurance; Guideline Premium Test and the Cash Value Accumulation Test.  The appropriate test for minimizing the life insurance is the GPT which uses one set of corridor factors to maintain an IRS mandated minimum amount of death benefit above the contract’s accumulated value.

The way it works is pretty simple, but the formula for determining is somewhat complex.  Basically you must keep a certain percentage of insurance compared to the cash value which starts at 250% at age 40 and decreases each year.  In order to accomplish minimizing the insurance and maximizing the cash value you need to think backwards from how traditional life insurance sales people normally sell life insurance.  You need to determine the premium amount and the length of time first.  Now we know that the fastest you can put the premium in is 4 years and 1 day.   So in the ideal world you would put the premium in that fast.  So if you have $100K to put into one of these you would put it in five annual payments.  However, if you don’t have a lump sum like that to put into it, you can decide to put $10K in for 10 years or $400/month until you turn 65 years old or any way you want to put in premium.  But the key is that it has to be decided up front.

So once, you decide on the premium amount and length of time, then companies software can figure out the face value of the insurance for you.  Once that is fixed then you are good to go.  Now it is important to understand that each year you put premium in the calculation is done.  So once you have stopped putting premium in there is no chance it would convert.  During the premium years, if there a problem then the company would decrease the premium amount it would allow to be put into the policy.  The good part of this is that means your cash value buildup is higher than what was predicted so the policy is performing better than expected.

Now beyond this is a couple of points.  First the seven pay rule limits the amount of premium paid in the first 7 years to the total amount that would be needed over the life of the policy to fund a paid up policy.  Second is a practical application which allows you to reduce the face amount of the universal life insurance policy [usually around year 11] because expenses are taken out largely in the first 10 years limiting your cash value build up.  In other words, just at the time your life insurance policy really starts to perform well you can further reduce the life insurance expense down significantly.  Then the policy face value will start to increase as you go forward with an increasing cash value.  So in year 11 you can call up the company and have your face value dropped [sometimes by 1/2] which will reduce your life insurance expenses dramatically.  Then the policy face value will automatically increase the face value as needed to maintain the proper amount of life insurance as your cash value increases.

So, lets review.  The policy is first set up with a set premium amount and time in mind.  Once the original face value is set it can never become a MEC.  Next, you can reduce the face value starting in year 11 to reduce expenses within the policy if you want.  If you want to maintain the face value [for whatever reason] you can do that.

What if you want to add more premium into the policy.   It is a possibility starting around year 11 as long as you stay within the guideline corridor rules.  However, I like the idea of reducing expenses more than I like the idea of increasing premium, so I generally think that it is best to initiate a new policy for the additional $$$ you want to put into an EIUL and reduce that face value of your current policy.

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Comments»

1. Mike - November 3, 2009

Dave, say you fund the policy in either 5 or 7 payments. Supposedly
you are then finished, correct? Do the rules allow you to make
contributions after the 5 or 7 payments solely for the purpose of
paying the expenses of the policy(COI and other expenses whatever
they may be) so that the cash value of the policy will grow faster?
If this is allowable, does it make sense to do so?

2. shaferfinancial - November 3, 2009

You can put more premium in down the line as long as you do not break the corridor rules for premium versus face value. However, I prefer to lower the face value down which lowers the expenses. Whenever you put premium in there are premium expenses involved. I like to get the expenses done over the first 10 years and then lower then down as much as possible for the life of the policy. When you lower the face value down it will automatically increase as needed to keep within guidelines. The policy itself is very flexible and allows you to do many different things. However, these policies work best over the long run when you minimize expenses up front and consistently as possible. That way you can get the expenses down to as low as 1% for the life of the policy.


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